The False Promise of Buybacks-Updated

Where Have Buybacks Gone, asks the Wall Street Journal? I cannot tell you how often I heard that buybacks were going to keep earnings strong (Ken Fisher in particular comes to mind.) As the Journal points out, that can dry up if people need the capital, or in a related issue, have loaded themselves up on debt to make past buybacks.

So what should investors, especially those of us allocating across asset classes rather than picking individual stocks, think about claims that share buybacks are a big positive:

Announcements do seem to be a short term positive, because investors and many in the media believe they are important, but long term many never occur! Hence the article I linked to. Pumping up the attractiveness of the stock market based on announcements ignore this fundamental problem.

Share repurchase programs are often a shell game. Generally new share issuance exceeds repurchases. The repurchase plans are announced to great fanfare, the issues of stock, and options on stock, are quietly distributed. While for any one company that may not be true, for the market as a whole it is. Let us quote Bill Bernstein and Rob Arnott :

[M]any investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks-stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year.

[...]

Investors were told the following:

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When earnings are not distributed as dividends and not reinvested into stellar growth opportunities, they are distributed back to shareholders in the form of stock buybacks, which are a vastly preferable way of distributing company resources to the shareholders from a tax perspective. True, except that over the long term, net buybacks (that is, buybacks minus new issuance and options) have been reliably negative.

Why does this happen?

Amongst other factors there is this. In research conducted by the Center for Financial Research & Analysis and the Corporate Library a disturbing, if predictable, pattern was noticed. They looked for companies with share repurchase programs while basing compensation of executives on earnings per share. Not earnings overall, but per share. They also wanted to see how many of these companies had negative cash flows over the two previous years. How many were in the S&P 500? 78. Worse, none of this was disclosed in their proxies. Warren Buffet described this practice in his usual witty style in 2005 (pdf .).

Management also often conducts stock repurchase programs while busily selling their own stock.

Repurchases only make sense if that is the best alternative for the cash used. When is that? – Only if the shares are undervalued. If not we should want the dividend. The unfortunate truth is that companies generally buy their shares back when they are going higher and on a run. Historically they have done a poor job of making that key investment decision. Recent history is instructive, buybacks kept picking up steam even as this current correction was approaching. Momentum investing is fine if that is what you want to do, but you hardly need management to do it for you.

The announcements often are accompanied by a bump in the price, causing the company to pay a higher price than otherwise.

The sheer size of the buyback programs can move the market, destroying some of the value.

Of course management which profits from stock options often doesn’t care. They want per share appreciation, the options don’t qualify for dividends.

Much of the recent binge of repurchase plans was carried out through debt. When this is done the entire effect is really one of leverage. The proper amount of leverage on the balance sheet is certainly open to discussion, but let us always be aware that leverage increases potential gains and losses. Higher risk should therefore mean a lower multiple on those earnings as well, diluting the expected boost to the stock. Given this leverage is often diluted by the factors above, but the cost of servicing that debt remains, we are left with reason to question repurchases as a productive strategy even more. If things get tight companies may need that cash. Dividends can be cut, cash can be drawn down, but the interest cost of that debt may remain.

But Buffett likes them! If Warren is on my board and has real power I have some faith in the decision on whether dividends, stock buybacks, or reinvesting cash flows makes sense. Generally I have far less faith in management or boards. He seems to feel the same way. Dividends don’t provide shares to send out the back door as compensation. Repurchases do.

Stock repurchases can be a good thing for an individual company, so can leverage, but we are asset allocators, and the total level of stock repurchases tells us nothing about whether that is a wise use of our capital of a diversified selection of stocks. In aggregate it should makes no difference to the value of an index. John Hussman explains that well here .

While there are tax benefits, given the issues surrounding them in practice, an explosion of repurchases as we saw in 1999 and this year, is a bad sign, not a good one. It shows irrational exuberance and carelessness with capital.

Even if it did not, it is certainly no positive to be preferred above paying a dividend or reinvesting cash flows. In aggregate the value of the companies stays the same. It can only increase returns (leaving aside taxes) by increasing leverage with all the risk that entails.

Update: I received some feedback from a couple of people, good friends Tim Randolph and Dale Franks. Both feel the agency feels the agency problem I discuss above is a major contributor. Here is an excerpt from Dale’s e-mail:

Once tax law shifted compensation from direct salary to stock options and other incentive types of pay, it really served to do little more than magnify the agency problem., i.e., executives gaming the agency relationship between managers and owners for thier own profit. I think repurchase programs are often little more than back door for executive to increase their compensation based on EPS.

At every step of the way since moving away from direct compensation, we’ve seen increasing agency problems, and corporate boards have just been abysmal at reigning in executives. Allowing executives to actually sit on the board–or practically as bad, nominate board members of their choosing–has resulted in all sorts of corporate governance failures.

I’d actually be interested now in looking at some research on the timing of repurchase programs and following re-issuance, because I suspect that a signifigant fraction of repurchases are nothing more than a scheme to puff up EPS–and perhaps stock prices–in the short term, then pay off the repurchases through a re-issue. But, to my mind, that only seems to work reliably if the stock price rises or at least remains stable betwen repo and reissue. If it doesn’t, then you either lose cash, increase debt, or issue new shares at a rate that’s dilutive.

In short, it’s the kind of thing you can do in a bull market without anyone noticing, but which becomes very noticeable in a bear market.

The thing is, if you do it through leverage, while it does bad things to your debt ratio, most investors just aren’t geeks enough to run your debt ratio, quick ratio, inventory turnover ratio, etc., etc. So, the risk isn’t as obvious. But most investors are least attentive enough to notice if you cut the dividend yield from 3% to 1%. They notice that real quick.

Tim posited that it was also a way for some executives to load the company up with debt, increase compensation and make them less attractive for LBO’s. Dale is skeptical. I’ll put it in the hopper as one issue.

Dale throws in that he is planning on posting some of his work on corporate governance reform. Looking forward to it.

The Wisdom of Warren Buffet

"In selecting an investment, an investor should adopt the same attitude one might find appropriate in looking for a spouse: it pays to be active, interested, and open minded, but it does not pay to be in a hurry."

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